Severance Payments Subject to FICA Withholding

The Supreme Court, reversing a decision of the Sixth Circuit, held that severance payments to terminated employees are subject to FICA withholding.

Background

Quality Stores was a large agricultural-specialty retailer, serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. In October 2001, the company filed for Chapter 11 bankruptcy. As a result of the bankruptcy, the company discontinued operations and eventually terminated all its employees. The employees received severance payments under either a prebankruptcy or a post-bankruptcy termination plan. Neither plan tied the severance payments to the receipt of state unemployment compensation benefits. The amount of the severance payments made under the plans varied based on the employees' job grade, management level, and length of service with the company.

Quality Stores reported the severance payments as wages on Forms W-2, paid the employer's required share of FICA taxes, and withheld employees' share of FICA taxes. It later asked 3,100 former employees to allow it to file FICA tax refund claims for them. The company filed refund claims on behalf of the former employees who agreed and on its own behalf. The IRS neither allowed nor denied the claim.

Quality Stores then filed a refund suit in bankruptcy court. The bankruptcy court found that the severance payments were not wages under FICA. The district court and the Sixth ­Circuit affirmed the bankruptcy court's decision. The IRS appealed to the ­Supreme Court, which, because of a split in the circuits on the issue, agreed to hear the case.

The Sixth Circuit's Decision

The Sixth Circuit found that the severance payments under the plans were supplemental unemployment benefits (SUBs) as defined in Sec. 3402(o), Extension of Withholding to Certain Payments Other Than Wages. Because the payments were covered by Sec. 3402(o), the court found that they were not wages for income tax purposes for two reasons. First, the title of Sec. 3402(o) referred to payments "other than wages," and the court inferred that this meant that Congress knew in enacting the statute that it was extending withholding to payments that were not wages. Second, the court cited several passages from the Senate report for the bill that included Sec. 3402(o), which directly stated that SUBs were not wages.

Finding that payments were not wages for purposes of federal income tax withholding, the court determined that supplemental unemployment compensation benefits also were not wages for FICA, based on the Supreme Court's decision in Rowan Cos., 452 U.S. 247 (1981). In Rowan, the Court concluded that because Congress defined wages almost identically for purposes of FICA and income tax withholding, it intended to coordinate the two statutory schemes "to promote simplicity and ease of administration."

The Supreme Court's Decision

The Supreme Court reversed the Sixth Circuit, holding that the severance payments made by Quality Stores under the plans were wages subject to FICA taxation. The Court found that the Sixth Circuit erred in basing its decision on Sec. 3402(o) instead of the FICA definition of wages in Sec. 3121(a). The Court concluded that severance payments fall under the broad definition of wages in FICA and that Sec. 3402(o), which Congress enacted to solve a narrow problem with income tax withholding, did not alter the FICA definition. In addition, the Court found that holding that the payments were exempt from FICA taxation but subject to income tax withholding would be contrary to its holding in Rowan.

The Supreme Court first examined whether the term "wages" for FICA purposes encompasses severance payments. Under Sec. 3121, wages include "all remuneration for employment," and employment is "any service, of whatever nature, performed . . . by an employee for the person employing him." Thus, the Court stated

Under this definition, and as a matter of plain meaning, severance payments made to terminated employees are "remuneration for employment." Severance payments are, of course, "remuneration," and common sense dictates that employees receive the payments "for employment."

The Court also observed that in its decision in Nierotko, 327 U.S. 358 (1946), service includes not only work actually done but the entire employee/employer relationship. Therefore, the fact that severance payments, such as those made under the Quality Stores plans, often vary according to function and length of service was confirmation that the payments were payments for employment and therefore were wages under the FICA definition.

The court next discussed whether Sec. 3402(o) limits the definition of wages for FICA tax purposes. The Sixth Circuit, accepting the company's argument, found that Sec. 3402(o)'s instruction that supplemental unemployment compensation benefits be treated "as if" they were wages for purposes of income tax withholding meant that the definition of wages for income tax withholding does not cover severance payments and that holding otherwise would render Sec. 3402(o) superfluous. The Court disagreed with this contention because severance payments fall within the broad definition of wages for income-tax-withholding purposes in Sec. 3401(a) and are not among the items specifically exempted from wages in that subsection. The Court also noted that treating all severance payments "as if" they are wages does not imply that all severance payments are not wages.

With respect to the argument that Sec. 3402(o)'s heading indicated that Quality Stores' severance payments under the plans were not wages, the Supreme Court found that this heading does not unambiguously exclude all severance payments from withholding because it only states that withholding is extended to "certain payments."

The Court also considered the regulatory background against which Congress enacted Sec. 3402(o). As the Court explained, in the 1950s and 1960s, some employers began providing SUBs, which are paid as supplemental benefits that terminated employees receive through existing state unemployment programs. However, some states' unemployment programs only provided benefits to terminated employees not earning wages. Therefore, at the urging of employers, the IRS took the position in several revenue rulings that SUBs that are tied to the receipt of state unemployment benefits are not wages for FICA and income tax withholding. Because the benefit payments remained taxable income, and income tax was not withheld, this had the practical effect of leaving terminated workers who received the benefit payments with large year-end income tax liabilities.

To prevent this result, Congress enacted Sec. 3402(o), which treats all severance payments, both SUBs as well as other severance payments that the IRS considers wages, "as if" they are wages subject to withholding, although it could have solved the immediate problem by limiting this treatment to SUBs. The Sixth Circuit took the position that Congress's enactment of Sec. 3402 meant that Congress intended all SUBs to be excluded from the definition of wages. The Supreme Court found that while the Sixth Circuit's assumption was "in the abstract not necessarily an illogical inference," given the regulatory background, it was unsustainable. The Court found instead that Congress extended the treatment to all severance payments simply to avoid having the same withholding problem arise again if the IRS later changed its position regarding which forms of SUBs were exempt from withholding.

Turning to Rowan, the Court stated that the major principle recognized in that case was that for simplicity of administration and consistency of statutory interpretation, the meaning of wages should in general be the same for income tax withholding and for FICA calculations. As the Court had already made clear, it believed that treating severance payments as not being wages would not be consistent with the definitions of wages under FICA and income tax withholding. In addition, the Court asserted that this treatment of severance payments would be inconsistent with the holding in Rowan that administrative reasons justify treating severance payments as taxable for FICA and income tax purposes. Consequently, the Court found that treating all severance payments as wages is consistent with its holding in Rowan.

Reflections

As the Court noted, the IRS continues to treat SUBs that are tied to the receipt of state unemployment benefits as exempt from both income tax withholding and from FICA taxation. Because the severance payments made by Quality Stores were not linked to state unemployment benefits, the Supreme Court did not address whether this exemption is consistent with the FICA definition of wages.